The Creep of Arbitrage Means Investing Is Mostly A Faith Exercise

The intellectual force-of-nature Byrne Hobart publishes a widely-read daily letter that I often pull from called The Diff. It’s in the same league as Stratechery or Matt Levine which is to say GOAT-level.

Byrne also publishes an educational post on Wednesdays in a letter called Capital Gains.

This week’s Capital Gains was one of my favorites. I’ll leave you with excerpts even though it’s pretty short. It’s one of those irreducible posts that should just be excerpted in full (said otherwise — just read it). There’s no waste.

[As usual, emphasis mine]

Risk and Returns, Before and After the Fact (Capital Gains)

There are two ways to talk about long-term returns from investing in a given asset class. One is easy because it has limited utility, and the other is a useful intellectual exercise, but impossible to get right.

• Long-term returns are, in a simplistic model, the current dividend yield plus long-term growth in dividends per share—where “long-term” is very long-term, like a lifetime or longer. And growth in dividends per share is, also in the very long term, a function of growth in revenue per share: margins tend to be surprisingly stable over long periods, and multiples can only go so far in one direction or another…This model looks too easy, and in some ways it is. For example, it’s correct over a timescale long enough to be irrelevant to individuals; there can be long swings towards lower margins, like the one that took place in the US from the 60s through the 90s. And there can be swings in the opposite direction, like the rise in corporate margins that’s taken place since then. But these trends can’t go on forever—each one of them could easily be the majority of the lifetime of a specific individual investor. Swings in valuation can happen, too; P/E ratios went from ~20x in the late 1920s (on low-quality earnings that were increasingly from financial engineering) to the mid-single digits in the late 1940s, back to 20+ in the 60s, back to single digits by the late 70s, and so on
  
• The discussion of fundamental drivers of equity returns hammered home the idea that valuation is not a driver of returns, because it moves so slowly. Even if the market switched from trading at ~10x earnings in the early 20th century to ~25x today, that’s 70 basis points per year of annual return. But the flip side of this is that over shorter periods, valuation’s role as a return driver goes way up. Year to year, the market’s moves are typically the result of multiple expansion rather than earnings growth or dividends…Over even shorter periods, valuation becomes even more important; an intraday swing or the change in price from one trade to the next are, almost by definition, overwhelmingly driven by valuation multiples rather than some tiny incremental update to a company’s fundamentals.
  
• In the very long run, stocks tend to go up. But that’s only sustainable if that long-term gain is compensation for some shorter-term variability. You can know roughly what you’re getting into by looking at broad valuation metrics, which tell you that stocks are fairly expensive right now, especially in the context of higher rates. But you can’t get much more information than that—the difficulty of timing the market is a function of how all the easy ways have been arbitraged away, and what’s left is a bedrock of uncertainty that, over short timescales, dominates fundamental drivers and long-term trends.

Money Angle for Masochists

I just want to attach a thought to Byrne’s post that seems cruel to dump on casual investors. Hence its home in the Masochism section.

If valuation is a limited return driver except over a long-run period, a period nobody knows anything about¹AND you are invested in managers who have valuation-based strategies, then Byrne’s post has Shrodinger’s cat vibes. There’s a duality of epistemology between the description of “what happened” with “what will happen” that really doesn’t seem to overlap in any pragmatic context. And the assumption of that overlap is the rationalization that underpins all long-term investing sales pitches.

Let’s back up and consider the problem of the long-term generally.

The best we can do is have sound frameworks for decision-making. Being probabilistic thinkers, understanding incentives, etc etc. All the stuff you hear on podcasts, Mungerisms, yadda yadda. It’s all sound even if it’s hard to implement in a messy world.

I feel that our frameworks have limited potential in outperforming the wisdom of crowds for long time horizons. Those frameworks help but their value is more in avoiding stupidity rather than aiding one in outperforming unemotional benchmarks that already incorporate intelligent portfolio construction logic — diversification, cutting losers (ie following trends) and rebalancing.

Everybody would love to hide behind “we are good at this in the long run and until that long run happens you shouldn’t judge us” while they collect nonrefundable fees. I don’t think there is data that you can look at that solves the problem of “who is good at beating benchmarks over the long term” for a price that doesn’t negate the advantage. But even price aside, how do you say “this buy-and-hold approach is better than a benchmark”? You need to believe they know something about the far future that other smart people do not. And the type of people that are good at that (if “that” exists) do not strike me as the same imaginations that are drawn to value investing.

The longer you hold an investment, the less your entry price matters. The most important driver of the investment will be the rate at which it compounds invested capital. A company that has the promise to do this is unlikely to be cheap. Everyone understands the math and understands that getting the entry price wrong is okay if they:

a) get business returns roughly right

and

b) don’t sell

The re-rating of the multiple matters more for the short to medium-term investor.

Doesn’t this put long-term investing at odds with the extreme couponing personas that value investors project?!

These other ideas make sense:

• Buffet preaches buying great businesses at fair prices
• Trader types are cool to buy a crap business they think is oversold but will re-rate when flows stabilize or there’s capitulation or whatever short-term thesis they envision materializes. They are just focused on beating the spread on the new slate of volatile stocks each week (or month).
• The growth investor appears to have internalized the idea that you can pay up for the best businesses and you’ll do great in the long run.

It’s the long-term value investors trying to buy pristine ROIC for bargain prices who appear to be spitting on the laws of investing gravity. Value investing seems like a mean reversion trade. “Trade” being the operative word here not “investing”.

The premise of long-term value investing appears logically incoherent when you try to marry “cheap” with “good business” in transparent public markets. Shorter-term strategies attract more competition (if you can “buy well” you’d like to exploit that skill 1000x a year rather than 5x a year) but they are at least possible to evaluate.

You could ask a manager, “What kind of things I should look at to figure out if your strategy is getting worse?” Tell me how to judge you. Tell me how to judge whether it even makes sense to try to get alpha in your space. There’s an old interview with an option guy Wayne Himelsein where he discusses strategy evaluation:

Are you achieving your premise? So you’ve said yourself, I know where I want to neutralize, and I know where I want to get my alpha. And if that’s where you get your alpha, you have to know that number one, you have alpha there. So if you look at your growth tilt and measure that against Fama growth factor, do you beat it? If not, you’ve got no edge.

He talks about mapping a strategy. Comparing the exposures to a time series of different exposures to see how it behaves.

“I don’t ever listen to what [the manager] tells me. I just run it versus we have in here about 180 different exposures that we have time series for factors or exposures [to find out] “what is inside this thing?”

How intentional are the exposures?

Managers will tell you that they’re doing something but don’t even know what they’re exposed to. “Did you know you have a 30% exposure to momentum? Oh, no, I didn’t. I’m actually a value investor.”

This is an older interview, but it’s increasingly common knowledge today that these lines of questioning inform pod shops’ risk and compensation frameworks.

This doesn’t work for choosing long-term investors.

The problem feels intractable.

You might convince me there are some weirdos who have first-hand tinkered with things that inform a vision of the far future. But they wouldn’t balk at the ticket price to board that ride anyway. They believe.

VC makes sense because overpaying doesn’t matter if you are truly drawing from a power law distribution (that’s a big “if” though).

And trading oriented managers can be evaluated. Just ask them the terms they want to be evaluated, hang them on their own inconsistencies, and choose from whoever’s left.

But long-term investors who want cheap prices? I don’t know if that job is even doable ex-ante and if it is I don’t think you wear a suit to do it.

I’ll let Byrne’s post provide the closing thought:

In the very long run, stocks tend to go up. But that’s only sustainable if that long-term gain is compensation for some shorter-term variability. You can know roughly what you’re getting into by looking at broad valuation metrics, which tell you that stocks are fairly expensive right now, especially in the context of higher rates. But you can’t get much more information than that—the difficulty of timing the market is a function of how all the easy ways have been arbitraged away, and what’s left is a bedrock of uncertainty that, over short timescales, dominates fundamental drivers and long-term trends.